udit committees of corporate boards of directors have come under increased scrutiny in the wake of numerous financial reporting improprieties and breakdowns in corporate governance. In a much-quoted September 1998 speech, SEC Chairman Arthur Levitt chided audit committees for not being more vigilant in their oversight function and called for “strengthening of the audit committee process” (see “Arthur Levitt Addresses Illusions,” JofA , Dec.98, page 12 ).
On the heels of Levitt’s address, the New York Stock Exchange and the National Association of Securities Dealers created the Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees, which moved quickly to issue recommendations geared to enhancing audit committee independence and director qualifications (see “Blue Ribbon Panel Issues Its 10 Commandments,” JofA , Apr.99, page 4 ). The blue ribbon committee urged the major U.S. securities exchanges and the SEC to require audit committees to be composed only of independent directors, with at least one committee member having accounting or related financial management expertise.
Shortly after the blue ribbon committee issued its recommendations, the authors conducted a survey of audit committees that provided insight into whether their effectiveness would improve if they were to adopt the BRC’s recommendations on independence and director qualifications. The findings should engage audit committees, auditors, regulators, standard-setters, corporate management and others with an interest in the role of audit committees in the financial reporting process and the likely impact of new rules on the committees.
Some observers expect the BRC’s rules on independence and director qualifications will result in audit committees that are more objective and competent in fulfilling their corporate governance responsibilities. Limited insight exists, however, into the effect these rules will have on the regularity of audit committee meetings and on the adoption of recommended committee activities. Among the questions are, for example, will independent audit committees that have at least one member who is qualified in accounting or financial management meet more frequently and for longer time periods than committees without such members? Will independent audit committees with expertise in accounting or finance be more proactive in reviewing internal controls?
SEARCHING FOR ANSWERS
The chief internal auditors of 123 large, public manufacturing companies responded to our survey which covered the composition of their audit committees, the directors’ qualifications and the committees’ reviews of certain internal audit proposals and results. We chose to pinpoint the chief internal auditors because of their availability, their role in corporate governance, their relationship with audit committees and their knowledge of audit committee reform issues. We selected publicly held companies because listing requirements at the major U.S. stock exchanges address audit committee composition. Relatively large, established companies also are likely to have strong audit committees and experience less difficulty in recruiting qualified directors.
The chief internal auditors reported how many of their company’s audit committee members matched the BRC’s description of an independent director—that is, an outside director having no affiliation with management besides being a member of the audit committee. The panel had noted in its report that several recent studies had found a correlation between audit committee independence and a higher degree of active oversight. The report said that independent directors are “more likely to be able to evaluate objectively the propriety of management’s accounting, internal control and reporting practices.”
Independence long has been regarded as crucial to ensuring audit committees fulfill objectively and effectively their oversight role. Hence, we did not conduct the survey to verify the accuracy of the statement, but to provide insight into the proportion of audit committees meeting this recommendation of the BRC as well as those not independent under its definition. This information is of interest because audit committee performance may be compromised when independence of its members is lacking.
The chief internal auditors also reported how many audit committee directors had prior work experience in accounting or finance, and/or professional certification. The blue ribbon committee had said that having at least one director with this work experience was crucial to an audit committee’s effective performance in light of the complexity of the accounting and financial matters it reviews.
The survey showed that 69% of the audit committees met the blue ribbon committee’s recommendations on independence and director expertise in accounting or finance (see exhibit 1 ). While this is encouraging, the concomitant finding that 31% of the committees lacked either independence or member financial expertise underscored the need for committee reform. If corporate governance and accountability are to improve, the panel’s recommendations addressing independence and director qualifications may be key.
Chairman Levitt had criticized audit committees that met infrequently and for too little time, performing essentially perfunctory duties. Since the BRC’s report is still relatively new, little is known about whether its recommendations on director independence and qualifications will lead to active and vigilant audit committees. To obtain insight into this issue, we classified the audit committees in the survey into two groups—those that were independent and had at least one qualified director, and those not meeting those two criteria.
The BRC’s report had included sample audit committee charters that required meeting “four times per year or more as circumstances require.” Exhibit 2 shows that in the survey 52% of audit committees satisfying the recommendations on director independence and qualifications met that frequently. In contrast, only 39% of “nonsatisfying” committees met that frequently. The average number of meetings per year for audit committees that met the panel’s criteria for director independence and qualifications was 3.6, a significantly greater frequency than the 3.2 average for committees that did not meet its criteria.
Exhibit 3 shows that independent audit committees with the recommended director expertise met an average of 96 minutes. By comparison, committees lacking independence or directors with financial sophistication averaged only 78 minutes.
Taken collectively, exhibits 2 and 3 suggest that the blue ribbon panel’s recommendations on independence and director qualifications might provide the impetus for audit committees to be more actively involved in the financial reporting process. Independent and qualified audit committees likely view their governance role as one requiring a significant time commitment and dedication to audit committee service.
The blue ribbon panel recognized “that quality financial accounting and reporting result only from effective interrelationships” between an audit committee, the outside auditors and management, including internal auditors. Successful corporate oversight requires a collaborative effort among these corporate participants. Since an audit committee has ultimate responsibility for overseeing the financial reporting process, it should develop and maintain a direct and strong relationship with internal auditors. The panel recommended that audit committees and internal auditors establish a line of communication to facilitate frank and confidential dialogue.
Although audit committee practices may vary depending on the nature or size of the business, the industry and the competitive environment, certain core activities the audit committee and internal auditors undertake reflect effective corporate oversight. One such core activity included in the BRC’s report was an audit committee review of the internal audit function, including the internal auditing budget, proposed audit plans for the coming year and how such plans reflect outside auditors’ objectives.
Another recommendation for a core activity was that, during the year, the audit committee review significant and unexpected internal audit findings and management’s response to them, as well as any difficulties or audit scope restrictions that internal auditors had encountered during the audit.
A focal point of this survey, and an issue of interest to the financial community, is whether audit committees that meet the BRC’s criteria for independence and financial expertise are more likely to engage in core activities. Exhibit 4 shows that 60% of the independent audit committees having director expertise in accounting or finance reviewed internal audit proposals. However, a significantly smaller proportion (29%) of the audit committees lacking either independence or financial sophistication engaged in this activity.
Exhibit 5 notes that a majority (65%) of the independent, financially sophisticated audit committees reviewed internal audit results and management’s response to them. In contrast, only 42% of the committees lacking independence or director financial expertise reviewed such findings and recommendations.
When considered together, the findings in exhibits 4 and exhibit 5 suggest that independent audit committees that satisfy the BRC’s recommendations on independence and director qualifications are more likely to view internal auditors as a valuable resource in overseeing the financial reporting process. They also suggest that independent and qualified audit committees may be more willing and able to investigate accounting irregularities, exceptions or other relevant matters, such as scope restrictions that management might impose.
It is realistic to expect that implementing the blue ribbon committee’s recommendations on independence and director qualifications will significantly improve audit committee performance. The results from this survey suggest that independent audit committees whose members have expertise in accounting or finance are more likely to execute their duties and act as reliable guardians of the public interest. They also seem inclined to collaborate with other corporate participants, such as internal auditors, in ensuring quality reporting and controls.
While the panel’s proposals hold promise for significant audit committee reform, change will not happen overnight. Real reform resulting in stronger corporate governance will likely occur in a gradual evolution that will require continual education.
WILLIAM J. READ, CPA, PhD, is professor of accountancy at Bentley College. He is a frequent contributor of articles to the Journal . His e-mail address is email@example.com . KANNAN RAGHUNANDAN, PhD, is professor of accountancy at Texas A&M International University. He has published in a variety of academic and professional accounting journals. His current research interest is audit committees and corporate governance. His e-mail address is firstname.lastname@example.org .